Stock ETFs Completely Decouple From U.S. Economic Concerns

NEW YORK (ETF Expert) -- Can we really attribute all of the horrendously weak economic data to icy pavements and polar vortexes? The Institute of Supply Management services sector report for February recorded its weakest data point in four years (51.6), posting a percentage decline that is the second worst ever.

In the same report, a sub-index on jobs showed that services sector employment actually contracted. Meanwhile, after-tax personal income for consumers dropped 2.7% from one year earlier -- a decline that rivals the struggles associated with 1973-1974.

It is not as if the U.S. economy has been registering a mixed bag of goodies. Most of the data have been strikingly poor. One might recall the ISM manufacturing sector survey for December plummeting by one of its largest percentage drops in its history, significantly contributing to the pullback in stock assets in the month of January. Others might recall the recent report on mortgage applications hitting lows not seen in nearly 20 years. Still others may recollect downward revisions to employment data and gross domestic product.

Granted, historically speaking, there is little correlation between a country's equity markets and the performance of its economy. However, there is plenty of evidence to suggest that fears of an economic downturn -- fears of inflation, stagnation, unemployment and underemployment -- often hurt stocks. Since nearly every equity segment is gaining ground and hitting fresh 52-week highs on Thursday (3.6.14), one can only wonder, "Where has investor uneasiness gone?"

The most obvious answer is the Federal Reserve's multi-year policy of electronic dollar creation and subsequent rate manipulation serves as a remarkable tonic for quelling bearishness on allocating to stocks. I definitely subscribe to the notion. After more than five years of zero-percent rates -- after numerous iterations of emergency level stimulus through unconventional bond buying programs -- Chairwoman Janet Yellen understands what investors need to hear.

"While the central bank's mandates of full employment and stable prices are clear, it is equally clear that the economy continues to operate considerably short of these objectives," she said. Translation? Regardless of what is causing economic woes, the Fed would consider modifying the pace at which it is slowing its bond purchases if their economic outlook softens considerably.

The ramifications are relatively straightforward. Do not sweat the troubles at retailers from RadioShack (RSH) to Best Buy (BBY) to Staples (SPLS); do not worry about the incredible decline in after-tax disposable income. We're a nation of spenders that will find a way to spend, particularly if the central bank of the United States makes certain that businesses and consumers have easy access to cash. Therefore, go right ahead and invest in consumer discretionary companies via the SPDR Sector Select (XLY) exchange-traded fund as well as retailers via the SPDR Retail (XRT).

Similarly, few would argue that we are in the earliest stages of the business cycle where profit and revenue growth is accelerating. Even fewer can argue that employment and income activity is rising when labor force participation is stuck in the 70s and personal income is struggling. Even credit growth is waning.

So it is a fair statement to suggest that we might be in the middle of an economic expansion or in the late-cycle phase with a single exception: massive policy accommodation by the Fed. That lone fact places a number of early-cycle stalwarts like basic materials at the front of the "for-your-consideration" pack. Indeed, SPDR Select Basic Materials (XLB) is riding a wave of excitement here in 2014.

To be clear, I continue to participate in the developed world bull market. I keep buying selloffs and dips. The difference is that I remain committed to non-cyclicals with less rate sensitivity like SPDR Select Healthcare (XLV) and iShares Defense & Aerospace (ITA). I also prefer less volatility in the equity exposure via funds like iShares USA Minimum Volatility (USMV).

When it comes to things like valuation alongside the promise of additional central bank intervention, small company exposure in the eurozone is a better "deal" than what one might want to pay for small-cap U.S. equities. That is why I have chosen to ride the relative strength run-up in iShares MSCI Small Cap EAFE (SCZ).

Still, decisions based on volatility, economic data, business cycle investing and/or regional valuation have not truly mattered. U.S. stock ETFs have completely decoupled from concerns about the U.S. economy. While a great deal of this is clearly attributable to central bank policies, Josh Brown of the Reformed Broker blog may have come up with another savvy explanation.

He wrote, "The vast majority of this snowballing asset base being reported by both wirehouse firms and RIAs is being put to work in a calm and methodical fashion: long-term mutual funds, tax-sensitive separately managed accounts and, of course, index ETFs. In fact, Vanguard's share of all fund assets -- now approaching 20% or $2.3 trillion -- is the vexillum behind which the entire do-less movement marches. It means that, almost no matter what happens, each week advisers of every stripe have money to put to work and they're increasingly agnostic about the news of the day."

How might one sum up the implication of this commentary? If Brown is right, the surging popularity of the fee-only management structure itself, where less transaction-based trading is the norm, cash goes into Vanguard stock indexing and it rarely leaves.

I'm not so sure. ETFs were meant to be traded, including Vanguard ETFs. It follows that there will be a bear market someday... and neither Fed policy nor fee-based registered investment advisers will be able to stop it from occurring. That said, the sensible registered investment advisers will have a plan in place to minimize losses when the inevitable bear shocks do-nothing participants.